Question

Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment.

 The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite).

 Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity.

 The cost of goods sold is estimated to be 72% of sales.

 The accounting department also estimates that at introduction in Year 0, the new product's required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year's cost of goods sold and accounts payable are expected to be 15% of the next year's cost of goods sold.

 The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted.

 The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year.

 The annual interest expense tied to the project is $1,000,000.

 Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%.

Determine the NPV of the project.

Answer 1

Only relevant costs will be considered in the capital budgeting analysis.

• $500,000 spent on the research of the potential market for the new chemical, is now a sunk cost and hence irrelevant.  
• The market research cost of $500,000 to be paid by the end of next year is again a sunk cost and hence irrelevant.  
• The annual interest expense of $1,000,000 is a financing cost and hence not considered in decision making.
• Only incremental selling, general and administrative expense = $6,000,000 -1,000,000 = $ 5,000,000 will be considered relevant and hence included in capital budgeting.
• Marginal tax rate of 30% should be considered

I will show you two snpashots. The first snapsot will have the figures and answers. The second snapshot will be in formula mode so that you know how to create this model at your end.

Snapshot 1

Please see the table below. All financials are in $.

Year, n	-	1	2	3	4	5	6	7
Sales		30,000,000	31,800,000	33,708,000	35,730,480	37,874,309	40,146,767	40,949,703
y-o-y growth			6%	6%	6%	6%	6%	2%
COGS		21,600,000	22,896,000	24,269,760	25,725,946	27,269,502	28,905,672	29,483,786
S, G & A expense		5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000
Depreciation		1,800,000	1,800,000	1,800,000	1,800,000	1,800,000	-	-
EBIT		1,600,000	2,104,000	2,638,240	3,204,534	3,804,806	6,241,095	6,465,917
Taxes		480,000	631,200	791,472	961,360	1,141,442	1,872,328	1,939,775
Unlevered net income		1,120,000	1,472,800	1,846,768	2,243,174	2,663,365	4,368,766	4,526,142
Working Capital Calculations
Inventory		4,579,200	4,853,952	5,145,189	5,453,900	5,781,134	5,896,757	-
Account Receivables		4,770,000	5,056,200	5,359,572	5,681,146	6,022,015	6,142,455	-
Account Payables		3,434,400	3,640,464	3,858,892	4,090,425	4,335,851	4,422,568	-
NWC level	6,000,000	5,914,800	6,269,688	6,645,869	7,044,621	7,467,299	7,616,645	-
Change in NWC	6,000,000	-85,200	354,888	376,181	398,752	422,677	149,346	-7,616,645
CF due to change in NWC	-6,000,000	85,200	-354,888	-376,181	-398,752	-422,677	-149,346	7,616,645
Unlevered Cash flows
Unlevered Net Income		1,120,000	1,472,800	1,846,768	2,243,174	2,663,365	4,368,766	4,526,142
[+] Depreciation		1,800,000	1,800,000	1,800,000	1,800,000	1,800,000	-	-
CF due to change in NWC	-6,000,000	85,200	-354,888	-376,181	-398,752	-422,677	-149,346	7,616,645
CF from capital expenditure	-9,000,000
Free Cash flows	-15,000,000	3,005,200	2,917,912	3,270,587	3,644,422	4,040,687	4,219,420	12,142,786
Year 5 terminal value						23,441,225
Discount factor		0.833	0.694	0.579	0.482	0.402	0.335
FCF present value	-15,000,000	2,504,333	2,026,328	1,892,701	1,757,534	1,623,862
NPV		4,225,259

Snapshot 2

AF AG lo =AF91+1 30000000 =72%*AG92 5000000 =-SAF$113/5 =AG92-SUM(AG94:AG96) =30%"AG97 AG97-AG98 AH AI AJ AK AL AM =AG91+1 =AH91+1 =A191+1 EAJ91+1 =AK91+1 =AL91+1 |=AG92"(1+AH93) =AH92*(1+A193) =A192*(1+A193) =A192" (1+AK93) =AK92*(1+AL93) =AL92*(1+AM93) 0.06 =AH93 -A193 -A193 AK93 0.02 =72%*AH92 =72%*A192 =72%AJ92 =72%*AK92 =72%"AL92 =72%AM92 =AG95 =AH95 =A195 =AJ95 =AK95 =AL95 =-SAF$113/5 --SAF$113/5 --SAF$113/5 =-SAF$113/5 0 0 =AH92-SUM(AH94:AH96) =A192-SUM(A194:A196 =AJ92-SUM(AJ94:AJ96) AK92-SUM(AK94:AK96) =AL92-SUM(AL94:AL96) EAM92-SUM(AM94:AM96) =30%*AH97 =30%A197 I=30%A197 =30%AK97 =30%"AL97 =30%AM97 =AH97-AH98 =A197-A198 =AJ97-A298 =AK97-AK98 =AL97-AL98 AM97-AM98 AE 91 Year, n 92 Sales 93 y-o-y growth 94 COGS 95 S, G&A expense 96 Depreciation 97 EBIT 98 Taxes 99 Unlevered net income 100 101 Working Capital Calculations 102 Inventory 103 Account Receivables 104 Account Payables 105 NWC level 106 Change in NWC 107 CF due to change in NWC 108 109 Unlevered Cash flows 110 Unlevered Net Income 111 [+] Depreciation 112 CF due to change in NWC 113 CF from capital expenditure 114 Free Cash flows 115 Year 5 terminal value 116 117 Discount factor 118 FCF present value 119 NPV 120 =20%*AH94 =15%*AH92 =15%AH94 =AG102+AG103-AG104 =AG105-AF105 =-AG106 =20%*A194 = 15%A192 =15%A194 =AH102+AH103-AH104 =AH105-AG105 =-AH106 = 20% AJ94 -20% AK94 =15%*AJ92 =15%*AK92 =15%AJ94 =15%* AK94 =A1102+A1103-A1104 |=AJ102+A1103-AJ104 =A1105-AH105 I =AJ105-A1105 =-A1106 =-A 106 =20%* AL94 =15%*AL92 =15%* AL94 =AK102+AK103-AK104 =AK105-AJ105 =-AK106 -20% AM94 =15%* AM92 =15% AM94 =AL102+AL103-AL 104 =AL105-AK105 =-AL 106 =20% A094 =15%*A092 = 15%A094 =AM102+AM103

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